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Tax Arbitrage by Colleges and Universities

Because colleges and universities serve a public purpose--advancing higher education and promoting myriad forms of research--they enjoy a variety of tax preferences. In addition to being exempt from paying federal income taxes, institutions of higher learning can accept tax deductible charitable contributions and use tax exempt debt to finance capital expenditures. It is the latter preference that CBO focuses on in this study, which was prepared at the request of the Ranking Member of the Senate Finance Committee. The law explicitly prohibits the use of tax exempt bond proceeds for the purchase of investment assets, a practice known as tax arbitrage; however, issuers of tax exempt bonds may use the proceeds for the purchase of operating assets while they simultaneously hold investment assets that provide a higher rate of return. To the extent that colleges and universities earn an untaxed return on investments that exceeds the interest they pay on tax exempt debt, they are benefiting from a form of indirect tax arbitrage.

Using data from information returns filed with the Internal Revenue Service by institutions of higher learning and by issuers of tax exempt debt, CBO created several measures of tax arbitrage under a broader definition of the term that includes indirect tax arbitrage. Over time, if legislators were to expand the definition of tax arbitrage, nonprofit institutions would most likely respond by reducing their issues of tax exempt debt. That response, in turn, could decrease the cost to the federal government of granting such tax preferences. In accordance with CBO’s mandate to provide objective, nonpartisan analysis, the paper makes no recommendations.